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The Transmission
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of Monetary Policy
GDP
Saving and
investment
channel
Domestic
Wealth Consumption prices
Interest rates channel and
Cash rate
and other for investment
monetary households
and Balance sheet
policy and cash flow Inflation
tools businesses
channel
Inflation expectations
Second Stage
The second stage of transmission is about how However, there is a large degree of uncertainty
changes to monetary policy influence economic about these estimates because the structure of
activity and inflation. To highlight this, we can the economy changes over time, and economic
use a simple example of how lower interest rates conditions vary. Because of this, the overall effects
for households and businesses affect aggregate of monetary policy and the length of time it takes
demand and inflation. (Higher interest rates have to affect the economy can vary.
the opposite effect on demand and inflation).
Inflation Expectations
Aggregate Demand Inflation expectations also matter for the
Lower interest rates increases aggregate demand transmission of monetary policy. For example, if
by stimulating spending. But it can take a workers expect inflation to increase, they might
while for the supply of goods and services to ask for larger wage increases to keep up with the
respond because more workers, equipment changes in inflation. Higher wage growth would
and infrastructure may be required to produce then contribute to higher inflation.
them. Because of this, aggregate demand is
By having an inflation target, the central bank can
initially greater than aggregate supply, putting
anchor inflation expectations. This should increase
upward pressure on prices. As businesses increase
the confidence of households and businesses in
their prices more rapidly in response to higher
making decisions about saving and investment
demand, this leads to higher inflation.
because uncertainty about the economy is
There is a lag between changes to monetary reduced.
policy and its effect on economic activity and
inflation because households and businesses take
time to adjust their behaviour. Some estimates
suggest that it takes between one and two years
for monetary policy to have its maximum effect.